The world's a pretty unfair place. Mariah Carey has had more No. 1 singles than anyone except Elvis and the Beatles. Paris Hilton has made a career out of being vacuous. The strong grow stronger, while the weak get trampled.
In the world of finance, you can make money from such inequality. Strong businesses tend to remain dominant during good times and bad. When downturns occur, everyone suffers, but it's the weak that go under. The strong not only survive, but also often come out ahead.
That's one reason why, at Motley Fool Inside Value, we hunt only for rock-solid companies. We closely examine their businesses, analyzing a host of metrics to ensure that we're purchasing stocks we think will succeed. Profit margin is one tool we use to distinguish the strong from the weak.
Margin is more than just a substitute for butter
Profit margins help you determine how effective a company is at converting sales into profits. The higher the profit margin, the more cash makes it to the bottom line.
Gross profit measures how much money a company makes after deducting raw material and manufacturing costs (which are lumped into the category of "cost of goods sold" or "cost of sales") from sales. Gross profit margin is the ratio of gross profit to sales, expressed as a percentage.
Suppose Dell (NASDAQ:DELL) sells a computer for $1,000. Let's assume components cost $750 and shipping costs $50. In this case, the cost of goods sold is $750 plus $50, or $800, and the gross profit is $1,000 minus $800, or $200. The gross profit margin, then, is gross profit ($200) divided by the sales ($1,000), or 20%.
That's a useful figure, but it doesn't indicate how effective a company is at actually making money. After all, in the real world, there's all manner of overhead: salaries, marketing, R&D, taxes, and so on. Once you've deducted all of those, you end up with net profit. Net profit margin is simply net profits divided by sales. Dell's net profit last year was $3 billion on $49.2 billion in sales, for a net profit margin of about 6%.
Who cares?
There are several reasons to care about profit margins, beyond the obvious fact that it shows how much money a company makes. A high margin can indicate that a company has a strong competitive position. Margins can vary dramatically by industry, but in general, I like to see a gross margin above 50% and a net margin above 7%.
Monopolies are great investments because such companies have the ability to raise prices -- which generally lifts margins -- without losing customers to competitors.
Warren Buffett evaluates potential investments by thinking about how hard it would be for a company to increase its prices. Businesses that can raise prices with ease get his seal of approval.
Buffett's firm, Berkshire Hathaway, doesn't hold a stake in Microsoft (NASDAQ:MSFT), but the software giant has very impressive margins. Software makers typically do have high margins, but with its gross profit margin of 81% and net profit margin of 29%, Microsoft is extraordinary. Because Windows and Office are standards for almost all businesses, Microsoft has a model very close to a monopoly. Consequently, it can charge whatever it wants for these products, resulting in huge margins -- a testament to its dominance. (Another testament is that Bill Gates, possibly the biggest geek of all time, is nevertheless revered.)
A caveat
Low margins aren't necessarily bad. Consider Wal-Mart (NYSE:WMT), which quite successfully plods along even though last year, for instance, its gross margin was 23.7% and its net margin was a scant 3.6%. Wal-Mart has relentlessly focused on reducing costs and passing savings on to the consumer. This model, with its emphasis on high sales volume, has resulted in an extremely successful low-margin business -- and one of the finest companies in the world.
McDonald's (NYSE:MCD) doesn't post exceptional margin when stacked up against many companies, but it's a great business nonetheless. Within an industry, margins can be used to determine which company is operating most efficiently. If one company has consistently higher margins than its competitors, there's a good chance it'll outperform over the long term. McDonald's, for instance, edges Wendy's (NYSE:WEN) on margins.
If a price war should develop, the company with the better margin will be more successful. Plus, that company will generally have more flexibility to take advantage of new opportunities. For example, I'd rather own Cisco (NASDAQ:CSCO), with a net margin close to 20%, than Juniper Networks (NASDAQ:JNPR), with a net margin closer to 10%. A couple of years ago, when the networking market was poor, Cisco made money even as Juniper ran a loss.
One other issue to consider is how a company's profit margin changes over time. It's good when profit margins increase because it means a company is managing costs well or that it's been able to increase prices. Decreasing profit margins are a red flag, possibly a sign of increased competition or that a company is unable to pass increasing expenses on to customers. If a company you own has decreasing profit margins, it's worthwhile to investigate and understand the cause and its long-term effect on profits -- if any.
What's next?
Profit margins are valuable to understanding a company's competitive position. I examine them every time I evaluate a stock. However, profit margins aren't adequate on their own for analyzing a company. That's why, at Inside Value, profit margins are just one part of our overall analysis. We consider myriad other factors to determine a company's intrinsic value, growth prospects, and whether it's overvalued or undervalued. In the end, lead analyst Philip Durell recommends only the companies that have significant profit potential. That's why we beat the market.
If you're interested in learning more about how we perform this analysis or want to see which companies we think are great buys right now, click here for a free 30-day trial to Inside Value.
Richard Gibbons owns calls on Cisco but doesn't have a financial interest in the other companies discussed in this article. Richard disses Mariah, Paris, and Bill out of a profound sense of inferiority. Dell is a recommendation of Motley Fool Stock Advisor. The Motley Fool has a disclosure policy.
